Corporate Tax Reform III: The new tax loophole

It is hard to work out the size of the gap that will be caused by Corporate Tax Reform III. USR II assumed a loss of 80 million francs to the federal treasury: Ultimately it amounted to several times that. Photo: Illustration of two black holes nearing each other and which will merge into one. An event that will trigger gravitational waves.

Corporate Tax Reform III was originally meant to eliminate the Swiss corporate tax haven. The notional interest deduction is now thwarting this intention entirely. It is also likely to harm developing countries.

In June 2016, the Federal Houses approved the draft of Corporate Tax Reform III (USR III). In reality, the draft law was intended to align Swiss tax policy with the new international standards of the OECD, EU and G20 and to eliminate the Swiss tax haven for corporations. At present, however, it is missing this original intention by a long way. A strong centre-right majority in Parliament has taken advantage of the reform bill to replace old special tax regimes with new ones and further fuel tax competition between the cantons. This will have dramatic consequences. It is feared that the Federal Government will face a tax shortfall of at least 1.5 billion francs per year, and some companies could be subject to an effective cantonal profit tax rate of just 3%. A broad coalition of Left/Green parties and trade unions have launched a referendum against this package, and submitted over 57,000 valid signatures on 6 October. The draft will be put to the ballot on 12 February 2017.

Corporate tax evasion costs the South 200 billion per year

From a development standpoint, problems will arise mainly from the various new special tax regimes which the Federal Council and Parliament wish to introduce through USR III to replace the old privileges for holding, domiciliary and joint-venture companies, which no longer meet OECD standards. Whether they create new possibilities for profit shifting within corporations with head offices in Switzerland and subsidiaries in developing countries will only become clear, in the event USR III is approved, when the ordinances are drafted. Democratically, this is problematic in that the real tax relief possibilities that will flow from USR III for multinational corporations will only become clear in these ordinances. The Federal Council is the body empowered to issue them. Tax loopholes often reside in the details of ordinances and neither voters nor Parliament have any further substantive input by that stage.

But what is already clear is that things like the patent box, the notional interest deduction, tax deductions for research and development spending, as well as the capital gains tax can basically serve as tools for profit shifting. This is wreaking havoc in the Global South. By International Monetary Fund (IMF) estimates, developing countries lose over 200 billion dollars per year through corporate tax evasion.

Conversely, the stakes could be considerable for low-tax location Switzerland if all the special tax regimes are not successfully replaced by new ones. According to the Federal Council, there are currently 24,000 enterprises in Switzerland with privileged tax status. They bring in roughly 4 billion to the Federal Government annually and are believed to employ some 135,000 to 175,000 people. Although this is just about 3.2% of all employees in Switzerland, it concerns some specific regions more than others. The Lake Geneva region, the Canton of Zug or the Basel region are home to numerous companies subject to special tax regimes. In the Basel Stadt Canton, for example, 50% of the entire profit tax take comes from privileged sources. Even the Basel SP Finance Director Eva Herzog, who at the start of the political process was understandably one of her party's few outstanding advocates of reform, recently intimated that she would have preferred the Federal Council's version of the draft law over that of the Parliament.

An idea for the OECD blacklist?

Anyone taking a closer look at the version of the notional interest deduction inserted by the Council of States into the draft bill at the very end of the resolution of differences procedure cannot help wondering what purpose this could serve at this time other than paving the way for profit shifting (see Box). The instrument allows enterprises to deduct capital gains (interest) on what is called the equity surplus, from taxable profit. However, owing to the Swiss National Bank's negative interest rate policy, the base rate is currently negative. This means that for now, companies cannot take advantage of this construct. Besides, no one knows how much longer the OECD will tolerate the notional interest deduction in the light of Belgium's undoubtedly negative experiences with it. The EU Commission too, in its latest proposals to combat tax avoidance, has also placed this tax on its hit list. Therefore, the instrument could well make it to a blacklist before the National Bank abandons its negative interest rate policy.

Tax legislation is a highly complex matter. It is fully understood mainly by specialized tax consulting firms and international consulting companies, which seek and find tax loopholes on behalf of their customers. Even more effective is introducing them already at the law-making stage through lobbying. The offshore industry here at home always manages to push through its interests by arguing that the attractiveness of Switzerland as a business location is at stake. On 12 February we will see whether this argument also garners majority support among voters.

Aside content

Tax and Finance Policy

How interest-adjusted profit tax becomes a loophole

The notional interest deduction allows for the interest rate on surplus equity capital to be set above the base rate established by the Swiss National Bank. This is possible provided that the capital gain is earned on an internal corporate loan. In this case, the offsettable interest rate is determined in keeping with the arm's length principle, whereby normal market interest rates must be used for any internal company loan. But the arm's length principle opens the way for interest rate manipulation, as the arm's-length comparison is often done in an arbitrary manner. It works as follows: the parent company in Switzerland wants to shift profits from its subsidiary in a high-tax African country to a low-tax Swiss canton. It makes a loan to the subsidiary at an interest rate so exorbitant that the interest payable by the subsidiary reduces its corporate profit substantially. Thus, the parent company's profit increases while that of the subsidiary declines. Thanks to the notional interest deduction, Swiss cantons therefore remain fiscally attractive locations for corporate head offices even after the elimination of holding company privileges.